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Finance and Economics Discussion SeriesDivisions of Research & Statistics and Monetary Affairs

Federal Reserve Board, Washington, D.C.

The Federal Reserves Balance Sheet: A Primer and Projections

Seth B. Carpenter, Jane E. Ihrig, Elizabeth C. Klee, AlexanderH. Boote, and Daniel W. Quinn

2012-56

NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminarymaterials circulated to stimulate discussion and critical comment. The analysis and conclusions set forthare those of the authors and do not indicate concurrence by other members of the research staff or theBoard of Governors. References in publications to the Finance and Economics Discussion Series (other thanacknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.

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TheFederalReservesBalanceSheet

Aprimerandprojections

SethCarpenter,JaneIhrig,ElizabethKlee,DanielQuinn,andAlexanderBoote*

August2012

Abstract

Overthepastfewyears,theFederalReservesuseofunconventionalmonetarypolicytoolshas

ledittoholdalargeportfolioofsecurities. Thesecuritiesholdingsinexcessofhistoricalnorms

havebeenshowntobeputtingdownwardpressureonlongerterminterestrates. One

questionaskedishowlongthisunusualamountofmonetarypolicyaccommodationwillbein

place. HereweprovideprojectionsoftheevolutionoftheFederalReservesbalancesheetthat

areconsistentwithpubliceconomicforecastsandannouncedFederalOpenMarketCommittee

policyprinciplestohelpanswerthisquestion. WebeginwithaprimerontheFederalReserves

balancesheet. Then,withthefoundationalconceptsinplace,wepresentaframeworkfor

projectingFederalReserveassetsandliabilitiesthroughtime. Intheprojections,theFederal

Reservesbalancesheetremainslargebyhistoricalstandardsforseveralyears. Ourbaseline

projectionsuggeststhatmarketparticipantslikelydonotexpecttheFederalReservesportfolio

toreturntoamorenormalsizeuntilAugust2017,anditscompositiontoreturntonormaluntil

September2018. Overall,thissuggeststhatmarketparticipantsbelievethatunconventional

monetarypolicywillbeinplaceforsometime,likelydepressinglongerterminterestratesfora

numberofyears.

*TheauthorsarestaffeconomistsandresearchassistantsintheDivisionofMonetaryAffairs,BoardofGovernorsoftheFederalReserveSystem,Washington,D.C.20551U.S.A. WethankJamesClouse,BillEnglish,MichelleEzer,

DonHammond,LawrenceMize,JulieRemache,ViktorsStebunovs,LisaStowe,JeffMoore,AriMorse,andBrett

Schulteforthoughtfuldiscussionsandassistance. Theviewsinthispaperaresolelytheresponsibilityofthe

authorsandshouldnotbeinterpretedasreflectingtheviewsoftheBoardofGovernorsoftheFederalReserve

SystemorofanyotherpersonassociatedwiththeFederalReserveSystem.

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1

1 IntroductionInresponsetothefinancialcrisisthatbeganin2007andthesubsequentrecession,theFederal

Reserveemployedavarietyofnontraditionalmonetarypolicytools. Theuseofthesetoolshas

had

a

significant

effect

on

the

Federal

Reserves

balance

sheet.

1

Both

the

size

and

the

compositionofthebalancesheethavechangednoticeably. AsshowninFigure1,through

2007,theassetsoftheFederalReserve(reportedabovethehorizontalaxis)comprisedmainly

Treasurysecurities. Thesinglelargestliabilityitem(reportedbelowthehorizontalaxis)was

FederalReservenotesthatis,currency. Priortothefinancialcrisis,theFederalReserves

balancesheetgrewatafairlymoderatepace,withtheOpenMarketDesk(Desk)attheFederal

ReserveBankofNewYorkpurchasingadditionalTreasurysecuritiesroughlyonpacewiththe

expansionofcurrencyandFederalReserveBankcapital.

Atthestartofthefinancialcrisis,theFederalReservesbalancesheetbegantoexpandata

fasterpacelargelybecauseofanincreaseoflendingthroughthevariousliquidityandcredit

facilitiesthatwereestablishedatthattime.2 Theseextensionsofcreditexpandedtheasset

sideofthebalancesheet,whileasubstantialportionofthematchingincreaseontheliability

sideofthebalancesheetshowedupinreservebalances.3 Astheseliquidityfacilitiesbeganto

winddown,theFederalReserveslargescaleassetpurchaseprogramsstartedtorampup. The

FederalReservesSystemOpenMarketAccount(SOMA)portfoliothatis,itsholdingsof

securitiesmorethantripledfrom2008totoday,andinJune2012exceeded$2.6trillion.

TheSOMAvalueof$2.6trillionisnearly$1.5trillionabovethecurrentvalueofcurrencyand

capital. Thevalueofcurrencyandcapital,plussomelevelofreservebalancesnecessaryforthe

conductofmonetarypolicywouldessentiallyreflectthenormalsizeofthebalancesheet

withoutthelargeamountofunconventionalmonetarypolicyaccommodationcurrentlyin

1 TheFederalReservesbalancesheetispublishedeachThursdayintheH.4.1statisticalrelease,availableat

http://www.federalreserve.gov/releases/h41/.2ForadiscussionoftheFederalReservescreditandliquidityfacilities,see

http://www.federalreserve.gov/monetarypolicy/bst.htm.3Throughoutthispaperthephrasereservebalanceswillbeusedtodenotedepositsofdepositoryinstitutions

thatarenotintermdeposits. Thismeasureisreportedintables8and9oftheH.4.1statisticalreleaseas

Deposits,Otherdepositsheldbydepositoryinstitutions. Thisconceptisslightlydistinctfromtheconceptof

reservebalancesreportedintable1oftherelease. Thatconceptexcludes,amongotheritems,contractual

clearingbalances.

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2

place. TheseexcessholdingsofsecuritiesbytheFederalReservehavereducedprivatesector

holdingsofthesesecurities,andhaveputdownwardpressureonlongerterminterestrates.4

HavingaprojectionofthebalancesheetthatisconsistentwithFederalOpenMarket

Committee(FOMC)guidanceandpubliceconomicforecastsprovidessomeguidanceonhow

marketparticipantslikelyanticipatemonetarypolicyaccommodationtoevolve. Studiesthat

aimtoquantifythecontemporaneousandexpectedfutureinterestrateeffectsoftheFederal

Reservesunconventionalmonetarypolicycanusetheseprojectionsasaninputintheir

analysis.5

TheCommitteesrecentstatementsabouttheoutlookformonetarypolicyanditsdiscussionin

theminutesoftheJune2011FOMCmeetingonexitprinciplessuggestthatthebalancesheet

couldremainlargebyhistoricalstandardsforsometime. Thispaperdescribesaframeworkfor

constructingprojectionsoftheFederalReservesbalancesheet. Theseprojectionsarenot

forecasts. Aswillbecomeclear,theprojectionsdependcriticallyonawholehostof

assumptionsaboutfuturemonetarypolicydecisions,financialmarketdevelopments,andother

issues. Basedonassumptionsandprojectionsofeachofthosefactors,onecaninferanimplied

pathforthebalancesheet. Theseprojectionsillustratehowthevariousfactorsthataffectthe

balancesheetoftheFederalReservedosodynamicallyandallowfortheanalysisofalternative

scenarios. Inthispaper,webaseourmodelingonthreekeyinputs. First,westartwiththe

FederalReservesbalancesheetasofMay30,2012. Second,weinterprettheminutesofthe

June2011FOMCmeetingtoputsomestructureonaplausibleexitstrategythatremoves

monetarypolicyaccommodation. Finally,werelyontheJune2012BlueChipEconomic

IndicatorsforecastfornominalGDPgrowthandinterestrates. TheBlueChipEconomic

Indicatorsisaconsensusforecastbasedonasurveyofprofessionalforecasters;weusethe

meanoftheforecastforourselectedeconomicvariables. Importantly,weusetheprojection

forthefederalfundsratetoidentifythetimingofthefirstexpectedincreaseinthefederal

4SeeYellen(2012)formorediscussionofhowtheFederalReservesbalancesheetoperationshavehad

substantialeffectsonlongertermTreasuryyields,principallybyreducingtermpremiumsonlongerdated

Treasurysecurities.5SeeIhrigetal.(2012)forastudythatprovidesanestimateofthecurrentandfutureexpectedpathofthe10year

termpremiumassociatedwiththeFederalReservesunconventionalmonetarypolicythatisconsistentwiththe

balancesheetprojectionsprovidedinthispaper.

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3

fundsrate,andweassumethatthevariouselementsoftheexitstrategyaretiedtothattiming.

AlloftheseinputsarepubliclyavailableandinnowayrepresentaforecastfromtheFederal

Reserveoritsstaff. Toillustratethedependenceoftheprojectionstotheassumptions,we

performaseriesofalternativesimulations.

Keyfindingsusingthebaselineassumptionsnotedabovearethefollowing. First,the

projectionsyieldaFederalReservebalancesheetthatremainslargebyhistoricalstandardsfor

anumberofyears. Inparticular,theSOMAportfoliocontractsatonlyaslowpacethroughthe

mediumterm,reflectingthefactthattheFOMChasstatedthatitanticipatesthatconditions

willwarrantkeepingthefederalfundsrateatexceptionallylowlevelsatleastthroughlate

2014. Moreoverthematurityextensionprogramisreducingtheholdingsofshorterdated

Treasurysecuritiesintheportfoliotoaboutzero,implyingthattherewillbelittlepassive

shrinkingintheholdingsofTreasurysecuritieswhenthereinvestmentpolicyisended. Under

theseprojections,theSOMAportfoliodoesnotreturntoamorenormalsizeuntilmid 2017,

anditscompositiondoesnotreturntonormaluntil2018. Iftheseprojectionsunderliethe

beliefsofmarketparticipants,theimplicationisthattheSOMAportfolioholdingsshould

continuetoputdownwardpressureonlongerterminterestratesforanumberofyears.

Thepaperisorganizedasfollows. Section2providesaprimerontheFederalReservesbalance

sheetandaccounting. Section3outlinestheassumptionsusedasinputstotheprojectionsof

thebalancesheet. ThebalancesheetprojectionsarediscussedinSection4. Section5

concludes. Twoappendixesarealsoincluded. Appendix1providesmoredetailonthe

assumptionsunderlyingtheprojections. Appendix2describesthemethodusedtoderive

projectionsofcouponsonfuturepurchasesofSOMAsecurities.

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4

2 Backgroundandhistoricalperspective2.1 TheFederalReservesbalancesheetOurdiscussionoftheFederalReservesbalancesheetwillrefertotheconsolidatedbalance

sheetsofthe12individualReserveBankbalancesheets.6 Inreality,theaccountingthatwillbe

discussedbelowisdoneattheReserveBanklevel;however,forsimplicity,wefocusonthe

FederalReserveSystemsaggregatebalancesheet.

Likeanybalancesheet,theFederalReservehasassetsononesideofthebalancesheet,which

mustequalliabilitiespluscapitalontheotherside. AsshowninTable1,attheendof2006,

totalassetsoftheFederalReservewere$875billion,withthesinglelargestassetitembeing

the

SOMA

portfolio,

at

about

$780

billion.

Prior

to

the

financial

crisis,

the

domestic

SOMA

portfoliocomprisedonlyTreasurysecurities,ofwhichroughlyonethirdwereTreasurybillsand

twothirdswereTreasurycouponsecurities.7 Ontheothersideofthebalancesheet,the

largestliabilityitemwaspapercurrency,orFederalReserveNotes(FRNotes),atabout$785

billion. FederalReservecapitalconsistsoftwocomponents,capitalpaidinandsurplus.8 By

statute,memberbanksmustsubscribetoFederalReserveBankcapitalinanamountof6

percentofeachmemberbankscapitalandsurplus,halfofwhichispaidin(thisportionis

referredtoascapitalpaidin)andtheotherhalfissubjecttocallbytheBoardofGovernors.

Whenamember'scapitalorsurpluschanges,itsholdingsofReserveBankstockmustbe

adjustedaccordingly. ReserveBankstockisquitedifferentfromstockinaprivatecompanyand

doesnotconferallofthecontrolsinthewaythatequityinprivatefirmsdoes. Surpluscapitalis

essentiallyretainedearnings,andisequatedtocapitalpaidin.

6TheBoardofGovernorsdoesnotholdassetsandliabilitiesinthesamewaythattheReserveBanksdo. Section10oftheFederalReserveActauthorizestheBoardtolevysemiannuallyupontheReserveBanks,inproportionto

theircapitalstockandsurplus,anassessmentsufficienttopayitsestimatedexpensesforthehalfoftheyear

succeedingthelevyingofsuchassessment,togetherwithanydeficitcarriedforwardfromtheprecedinghalfyear.7ItisworthnotingthatthereisacommonmisperceptionthattheFederalReserveonlyheldTreasurybillspriorto

thelargescaleassetpurchases.8SeetheFinancialAccountingManualforFederalReserveBanks,whichreportstheaccountingstandardsthat

shouldbefollowedbytheFederalReserveBanksat

www.federalreserve.gov/monetarypolicy/files/bstfinaccountingmanual.pdf, pageI68.

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6

Historically,thesizeoftheSOMAportfolioandthebalancesheetmoregenerallyreflected

growthinFRNotesandReserveBankcapital. Whencurrencyisputintocirculation,itis

shippedtoadepositoryinstitutionandthatinstitutionsaccountattheFederalReserveis

debitedbyanequivalentamount. Becausecurrencyoutstandingtendstotrendupward,over

timecurrencygrowthwouldtendtoreducetheamountofreservebalancesinthebanking

system. TheFederalReservewouldpurchasesecuritiesinopenmarketoperationstooffsetthis

drainofreserves. Onnet,therefore,thegrowthrateofcurrencytendedtodrivethesizeofthe

balancesheet. Similarly,whenadepositoryinstitutionsubscribestoalargeramountofFederal

ReservecapitalortheFederalReserveaddstoitssurplusaccount,theresultwouldbeallelse

equalareductioninreservebalances. Asaresult,theSOMAportfoliomustincreasetooffset

theseincreasesaswell,creatingalargerbalancesheetoverall.

ThishistoricalpatternisillustratedinFigure2. Ascanbeseen,through2007,boththeSOMA

portfolioandcurrencyandcapitaltrendedupwardtogether. WhentheLSAPsbeganinlate

2008andearly2009,andcontinuingthroughthesecondroundofpurchasesin2010,theSOMA

portfolioincreasedmarkedlyandataratethatfaroutpacedthegrowthofcurrencyandcapital.

TheexpansionoftheSOMAportfolioatthatpointwasreflectedinreservebalances.

TheSOMAportfoliohasarangeofmaturitiesofTreasurysecuritiesinitsholdings.13

Historically,theDesktendedtopurchasesecuritiesacrosstheentireyieldcurvetoavoid

distortingtheyieldcurve. AsshowninFigure3,theweightedaveragematurityofTreasury

couponsecuritiesintheSOMAportfoliostayedaroundthreetofouryears. Afterthestartof

thefinancialcrisis,thematurityofTreasurycouponsecuritiesintheSOMAportfoliolengthened

notably,reflectingtherunoffinbillstosterilizethecreditandliquidityprogramsin2008and

thepurchaseoflongerdatedsecurities.

2.1.2 PremiumsanddiscountsFederalReserveaccountingrecordsalldomesticsecuritiesholdingsatfacevalue,ratherthanat

marketvalue. ExceptfortherolloverofmaturingTreasurysecurities,newpurchasesof

13IntheweeklyH.4.1statisticalrelease,inadditiontotheFederalReservesbalancesheet,thematurity

distributionofassetholdingsisalsopublished.

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7

securitiesareconductedintheopenmarketatmarketprices. Ifasecurityispurchasedfor

morethanitsfacevalue,thedifferencebetweenthepurchasepriceandthefacevaluethe

premiumonthatsecurityisrecordedseparatelyasanassetonthebalancesheet. Likewise,if

asecurityispurchasedforlessthanitsfacevalue,thedifferencebetweenthepurchaseprice

andthefacevaluethediscountonthatsecurityisrecordedasaliabilityonthebalance

sheet. Reservebalancesincreasebythepurchasepriceofthesecurity,thatis,thefacevalue

plusthenetpremium(premiumsnetofdiscounts). Atmaturityofthesecurity,theFederal

Reservewillonlyreceivethefacevalue,sothepremiumsanddiscountsmustbeamortized

overtheremainingtermofthesecurity. U.S.Treasurysecuritiesandagencydebtsecurities

heldbytheFederalReserveBanksareamortizedlinearlyovertheremainingtermofthe

security. IntheaccountingtreatmentofagencyMBSpremiums,theamortizationschedulefor

MBSisbasedonaneffectiveyieldcalculation,whichresultsinaconstantrateofreturnduring

thetermofthesecurity. Intheanalysisthatfollows,however,wesimplifythisassumptionand

implementagencyMBSamortizationusingthepathofanticipatedpaydownsofagencyMBS.

Asofyearend2011,therewere$88billioninunamortizedpremiumsand$1billionin

discountsassociatedwithholdingsofTreasurysecuritiesand$12billioninunamortized

premiumsand$1billionindiscountsassociatedwithholdingsofagencyMBS.14

2.1.3 LendingSinceitsinception,theFederalReservehashadtheauthoritytolendtodepositoryinstitutions.

Priortothefinancialcrisis,however,borrowingfromtheFederalReservetendedtobequite

small,typicallylessthanacouplehundredmilliondollarsoutstandingperday. Duringthe

financialcrisis,lendingbytheReserveBanksgrewsignificantly,atonepointexceeding$1

trillionoutstanding.15 LendingbytheFederalReserveincreasesreservebalances,allelseequal,

becauseinlendingtoadepositoryinstitution,theReserveBankdirectlycreditsthat

institutionsreserveaccount. Asaresult,reservebalancesroseaslendingincreasedduringthe

14RefertotheCombinedFinancialStatementoftheFederalReserveSystem,availableat

http://www.federalreserve.gov/monetarypolicy/bst_fedfinancials.htm.15Includedinthisnumberareprimary,secondaryandseasonalloans;termauctioncredit;theprimarydealerand

otherbrokerdealercredit,creditextendedtoAIG,netportfolioholdingsofCommercialPaperFundingFacility,

andtheoutstandingprincipalamountofloansextendedbytheFederalReserveBankofNewYorktoMaidenLane,

MaidenLaneII,andMaidenLaneIII.

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8

financialcrisis. TheloantotheinstitutionisthecorrespondingassetontheFederalReserves

balancesheet.

2.1.4 DepositsofdepositoryinstitutionsandreverserepurchaseagreementsDepositsofdepositoryinstitutionsincludebalancesattheFederalReserveofalldepository

institutionsthatareusedtosatisfyreserverequirementsandbalancesheldinexcessofbalance

requirements,aswellasservicerelateddeposits. Depositsofdepositoryinstitutionsgrew

dramaticallythroughthecrisis,andarecurrentlyquiteelevatedbyhistoricalstandards. When

werefertoreservebalances,weareusingthedepositsofdepositoryinstitutionsconcept.

Thesedepositsrepresentfundsthatdepositoryinstitutionsowntheyarealiabilityofthe

ReserveBank,butanassetofthedepositoryinstitution. Thesefundsarealsousedforpayment

systemsettlementforexample,apaymentfromonebanktoanother(orfromonebanks

customertothecustomerofadifferentbank)typicallyresultsinadebittothepayingbanks

accountandacredittothereceivingbanksaccount. Lendingofreservebalancesandpayment

activityresultonlyinamovementofreservebalancesfromonedepositoryinstitutionsaccount

attheFederalReservetoanotherinstitutionsaccount;theaggregatequantityisunchanged.

2.1.5 ReverserepurchaseagreementsTheFederalReserveconductsreverserepurchaseagreements(reverserepos,orRRPs)by

sellingsecuritiestocounterpartieswhosellthesecuritiesbacktotheFederalReserveona

statedfuturedate. Currently,thelargestportionofoutstandingreversereposiswithforeign

centralbanksthatholddollarsintheiraccountsattheFederalReserveBankofNewYork.

KnownastheforeignRPpool,asofendMay2012,therewasalittlelessthan$100billionin

foreignRPpooltransactionsoutstandingontheFederalReservesbalancesheet.

InadditiontotheforeignRPpool,beforethefinancialcrisis,theFederalReserveoccasionally

engagedinreversereposwithprimarydealerstodrainreservebalances. Thesetransactions

areconceptuallydistinctfromtheserviceprovidedbytheforeignrepopool;inparticular,they

areintendedtobepartofopenmarketoperationsandthereforepartoftheconductof

monetarypolicy. Sincelate2009,theFederalReserveBankofNewYorkhastakenstepsto

expandthetypesofcounterpartiesforreverserepostoincludeentitiesotherthanprimary

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dealers,inordertoprepareforthepotentialneedtoconductlargescalereverserepurchase

agreementtransactions.

2.1.6 FederalReserveNotesFederalReservenotes,orcurrency,arealiabilityoftheFederalReserve. Asapracticalmatter,

thequantityofcurrencyoutstandingisnotdeterminedbytheFederalReserve. Instead,when

adepositoryinstitutionwantstoholdcurrencyinitsvaultorautomatictellermachinesinorder

tomeetcustomerneeds,itrequestsashipmentfromitsFederalReserveBank. Whenthat

shipmentismade,thedepositoryinstitutionsreserveaccountattheReserveBankisdebited

bytheamountofthecurrencyshipment. OneimportantsourceofdemandforU.S.currencyis

fromoverseas. Althoughitisimpossibletoknowwithcertaintywhatportionofcurrency

outstandingisoutsideoftheUnitedStates,estimatessuggestthatthefractionisonehalfor

more.16 Priortothefinancialcrisis,currencywasthelargestliabilityitemontheFederal

Reservesbalancesheet.

2.1.7 Capitalpaid-in,surplus,andinterestonFederalReservenotesduetoU.S.Treasury

ThecapitaloftheReserveBanksisdifferentthanthecapitalofotherinstitutions. Itdoesnot

representcontrollingownershipasitwouldforaprivatesectorfirm. Ownershipofthestockis

requiredbylaw,theReserveBanksarenotoperatedforprofit,andthestockmaynotbesold,

traded,orpledgedassecurityforaloan. AsstipulatedinSection5oftheFederalReserveAct,

eachmemberbankofaReserveBankisrequiredtosubscribetothecapitalofitsdistrict

ReserveBankinanamountequalto6percentofitsowncapitalstockandsurplus. Ofthis

amount,halfmustbepaidtotheFederalReserveBanksandhalfremainssubjecttocallbythe

BoardofGovernors. Thiscapitalpaidinisarequiredassessmentonthememberbanksandits

sizechangesdirectlywiththecapitalofthememberbanks. Alsostipulatedbylawisthat

dividendsarepaidatarateof6percentperyear. Overthepastdecade,reflectingincreasesin

capitalatmemberbanks,reservebankcapitalhasgrownatanaveragerateofabout15

percentperyear. Inaddition,ReserveBankshavesurpluscapital,whichreflectswithheld

16RefertoJudsonandPorter(1996).

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10

earnings,andFederalReserveaccountingpoliciesstipulatethattheReserveBankswithhold

earningssufficienttoequatesurplustocapitalpaidin. Asaresult,ascapitalofmemberbanks

growsthroughtime,capitalpaidingrowsinproportion. Becausesurplusissetequaltocapital

paidin,itlikewisegrowsatthesamerateasmemberbankcapital.

Oneliabilityitemisdistinctfromtheothers. Asnotedabove,theFederalReserveremitsallnet

income,afterexpensesanddividendsandallowingforsurplustobeequatedtocapitalpaidin,

totheU.S.Treasury. Asthoseearningsaccrue,theyarerecordedontheFederalReserves

balancesheetasInterestonFederalReservenotesduetoU.S.Treasury. Intheeventthat

earningsonlyequaltheamountnecessarytocoveroperatingcosts,paydividends,andequate

surplustocapitalpaidin,thisliabilityitemwouldfalltozerobecausetherearenoearningsto

remitandthepaymenttotheTreasurywouldbesuspended. Ifearningsareinsufficientto

coverthesecoststhatis,thereisanoperatinglossinsomeperiodthennoremittanceis

madeuntilearnings,throughtime,havebeensufficienttocoverthatloss. Thevalueofthe

earningsthatwouldneedtoberetainedtocoverthislossiscalledadeferredassetandis

bookedasanegativeliabilityontheFederalReservesbalancesheetunderthelineitem

InterestonFederalReservenotesduetotheU.S.Treasury.

OneconsequenceofthecurrentimplementationofFederalReserveBankaccountingpolicyis

thattherecordingofadeferredassetimpliesthatReserveBankcapitaldoesnotdeclineinthe

eventofanoperatingloss. Fromtimetotime,individualReserveBankshavereporteda

deferredasset;however,thesedeferredassetsweregenerallyshortlived.17 Ithasneverbeen

thecasethattheFederalReserveSystemasawholehassuspendedremittancestothe

Treasuryforameaningfulperiodoftimebecauseofoperatinglosses.

2.1.8 OtherliabilitiesTheFederalReserveactsasfiscalagentfortheU.S.Treasury. TheTreasuryholdstwoaccounts

attheFederalReserve,whicharetheTreasurysGeneralAccount(TGA)andtheSupplemental

17Forexample,asshownontheH.4.1StatisticReleasefromNovember3,2011,theFederalReserveBankofNew

YorkrecordedalargeenoughdeferredassetsothattheFederalReserveSystemalsodid.

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FinancingAccount(SFA).18 TheTGAistheprimaryaccountthroughwhichtheTreasurys

transactionssettle. MajoroutlaysoftheU.S.Treasuryaregenerallymadefromthisaccount

andtaxreceiptsaredepositedinthisaccount. TheTGAisalsousedtocollectfundsfromsales

ofTreasurydebt. Priortothefinancialcrisis,theTreasurymanagedthebalanceinthisaccount,

whichreceivesnointerest,toalevelofabout$5billioneachday,andinvestedanyadditional

fundsinthebankingsystem. TheTreasurytraditionallyreceivedthefederalfundsratelessa

spreadonfundsithadinvestedindepositoryinstitutions. Sincelate2008,thefederalfunds

ratehasbeenclosetozero,andtheTreasuryhasplacedessentiallyallofitsoperatingcashin

theTGA.19

TheSFAwasestablishedbytheTreasuryinSeptember2008toholdtheproceedsofthe

SupplementaryFinancingProgramandtocoordinatewiththeFederalReserveinthe

managementoftheaggregatequantityofreservebalances. Underthisprogram,theTreasury

issuesmarketabledebtanddepositstheproceedsinanaccountattheFederalReservethatis

segregatedfromtheTGA. Onanumberofoccasionsasthestatutorydebtlimitappearedtobe

binding,theTreasuryreducedthequantityofdebtissuedundertheSFP,therebyreducingthe

balanceintheSFA. TheSFAfelltozeroinlateJuly2011andhasstayedatthatlevel

subsequently.

Thereareasetofotherliabilitiesthatwedonotdiscussindetailbecausetheyare,ingeneral,

eithersmallornotparticularlyrelevantforthepurposesoftheseprojections. Morediscussion

oftheFederalReservesbalancesheetisavailableontheBoardofGovernorswebsite.20

2.2 ValuationoftheSOMAportfolioThereareanumberofdifferentwaystorecordthevalueoftheSOMAportfolio. ReserveBank

accountingrecordstheSOMAportfolioatparvalue. Theparvalueoftheportfolio,reportedin

line1ofTable2,givesthefacevalueofthesecuritiesintheportfolio. Thisisthevalueofthe

18Technically,theTreasuryhasageneralaccountateachReserveBank,howeverinpracticetheseaccountsare

consolidatedeachnightintothegeneralaccountattheFederalReserveBankofNewYork.19Seehttp://www.fms.treas.gov/tip/communication/specialcommunication2008.pdffortheTreasurys

announcementofthesuspensionofitsTermInvestmentOptionauctions.20http://www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm

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portfolioreportedintheweeklyH.4.1statisticalrelease. Theamortizedcostoftheportfolio,

alsocalledthebookvalueoftheportfolioandshowninline3,istheparvalueoftheportfolio

plusanyunamortizednetpremiumsassociatedwiththesecurities. Athirdvaluationofthe

portfolioisthemarketvalue,line4. TheMonthlyReportonCreditandLiquidityProgramsand

theBalanceSheetandtheAnnualReportalsoreportthefairvalueoftheportfolio.21 As

interestrateschange,themarketvalueofthesecuritiesintheportfoliochanges. The

differencebetweenthemarketvalueandthebookvalueistheunrealizednetgain(orloss)

positionoftheportfolio,line5. AsoftheendofMarch2012,theportfoliohadanunrealized

gainof$177billion,reflectingagainoneachofthethreetypesofsecuritiesholdings.22 March

2012isthelastpublishedinformationonthepositionoftheportfolioasofthewritingofthis

paper;however,asimilarcalculationispossibleatroughlyanytime. Inparticular,theFederal

ReserveBankofNewYorkpublishestheCUSIPofeverysecurityheldintheSOMAportfolio.

CombiningtheseCUSIPswithmarketpricesforthesecuritiesallowsforthecalculationonany

dayofthemarketvalueoftheFederalReservesportfolio.23

Table2:ValueoftheSOMAportfolioasofMarch31,2012

($billions)

Treasuries AgencyDebt AgencyMBS TotalSOMA

1.Par

value*

1,665 96 837 2,598

2.Netpremiums 99 4 12 115

3.Amortizedcost 1,764 100 849 2,713

4.Marketvalue 1,892 106 892 2,890

5.Gain/Loss 128 6 43 177

21ThequarterendmarketvalueoftheSOMAportfolioispublishedintheMonthlyReportonCreditandLiquidity

ProgramsandtheBalanceSheet,availableathttp://www.federalreserve.gov/monetarypolicy/clbsreports.htm,

withalag. Alternatively,theFederalReserveBankofNewYorkpublishestheCUSIPsofallofthesecuritiesinthe

FederalReservesportfolio. MatchingtheseCUSIPswithcurrentmarketpricesallowsforanestimateofthe

currentmarketvalueoftheportfolio.22Importantly,eveniftheSOMAportfoliowasinanunrealizednetlossposition,theabilityoftheFederalReserve

toimplementmonetarypolicywouldnotbehampered.23Inaddition,theamortizedcostoftheportfolioisrequired. Inrealtime,amortizedcostcanbeeasily

approximatedbytheparvalueoftheportfolio,whichispublishedweekly,andthenetunamortizedpremiums,

whichareincludedintheweeklypublicationofthebalancesheetandareexplicitlypublishedquarterly.

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*ParvalueasofMarch28,2012fromtheH.4.1StatisticalRelease.

Source:MonthlyReportonCreditandLiquidityProgramsandtheBalanceSheet,June2012.

3 ProjectionsassumptionsInordertoconstructprojectionsoftheFederalReservesbalancesheet,assumptionsabout

manyofthedetailsofthebalancesheetanditsevolutionmustbemade. Thefollowing

subsectionsreviewassumptionsmadeaboutkeylineitemsofthebalancesheet. Adetailed

descriptionoftheseandadditionallineitemsisfoundinAppendix1.

3.1 InterestrateassumptionsToevaluatethecurrentandfuturevalueofsecurities,andthereforetheSOMAportfolio,

assumptionsmustbemadeaboutthepathofinterestratesovertheprojectionperiod. Forthis

analysis,werelyoninterestrateprojectionsfromtheJune2012BlueChipforecastforthe

federalfundsand10yearTreasuryinterestrates. Theresultsofthesimulationspresentedin

thispaperwouldbedifferentunderalternativeassumedpathsformarketinterestrates. The

assumedpathforthefederalfundsrateandtheyieldonthe10yearTreasurynoteareshown

inFigure4. Thefederalfundsrateremainsinthe0topercentrangeuntiltheendof2013.

ThisforecastisthemeanoftheBlueChipsprofessionalforecastersresponses,andthe

forecastdoesnotrepresenttheviewsoftheFederalReserveoritsstaff.24 Afterthatpoint,

interestratesareprojectedtoriseandattheendoftheprojectionperiodin2020,thefunds

ratestandsat3.6percent. TheyieldonthetenyearTreasurynotealsorises,fromitscurrent

lowlevelof1.96percentto4.9percentattheendoftheprojectionperiod.

Toperformtheassetvaluationsthatwillberequired,however,anentireyieldcurveisneeded.

Asaresult,wecreateayieldcurveateachpointintimeovertheprojectionperiodusing

historicalrelationshipsbetweenthefederalfundsrate,the10yearTreasuryrateandselected

intermediatetenors. Assetvaluationisneeded,forexample,toprojecttheeffectonreserves

ofsellingMBSasenvisionedintheFOMCsexitprinciples. Thehigherthemarketvalueofthe

24TheJanuarythroughAugust2012FOMCstatementsindicatedthatthefederalfundsratewouldremainat

exceptionallylowlevelsatleastthroughlate2014. Laterinthepaper,weprovideanalternativescenariowhere

thefederalfundsratedoesnotriseabovepercentuntilOctober2014.

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security,themorereserveswouldbedrainedthroughthesale. Thelowerthemarketvalue,

thereversewouldbetrue. MoredetailsareprovidedinAppendix2.

3.2 Near-termbalancesheetassumptionsThissubsectionreviewsourprojectionmethodologyforselectedassetandliabilityitemsthat

areofparticularinterest. Allelementsofthebalancesheetareprojected,butweleavethose

oflessinteresttoAppendix1.

3.2.1 SOMAportfolioTheevolutionoftheSOMAportfolioisintendedtobeconsistentwiththeFOMCstatementon

June20,2012. Inparticular,weassume

(1)Thematurityextensionprogram(MEP),whichstartedinSeptember2011,iscontinuedthroughtheendof2012. WeassumethattheDeskconductssalesofshorterdated

Treasurysecuritiessothatsalesandredemptionstotalabout$44billiononaverageper

monthandpurchasesoflongertermTreasurysecuritiesofasimilaramountinthe

secondarymarketthroughtheendof2012;and

(2) ReinvestmentofprincipalpaymentsfromagencysecuritiesintoagencyMBScontinuesinthenearterm.

Bynearterm,wemeantheperiodoftimebetweennowandthebeginningofanexitstrategy

fromthecurrentaccommodativemonetarypolicystance.25 Giventheinitialcompositionofthe

SOMAportfolioonMay30,2012,theportfolioevolvesovertime. Weadjustthematurity

structureofholdingsofTreasurysecuritiesandagencysecuritiesthroughtimetoreflectthe

salesandpurchasesoftheMEPalongwiththereinvestmentpolicyandthepassageoftime.

Moreover,theforecastforfuturepurchasesimposestheconstraintthatSOMAholdingsofany

oneCUSIPremainbelow70percentofthetotalamountoutstandinginthatCUSIP,as

announcedbytheFederalReserveBankofNewYork.

SimilartotheuseofBlueChipprojectionsforinterestrates,weturntopublicprojectionsfor

theTreasurysissuanceofmarketabledebt. Weuseprojectionsofboththeamountandthe

25TheexitstrategyandothertimingissueswillbediscussedinfurtherdetailinSection3.3.

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maturityofTreasuryissuanceinordertoprojectsecuritiesavailableforpurchasebytheFederal

Reserve. WeuseTreasuryissuanceasofMay2012,andfromthatpointforward,coupledwith

theCongressionalBudgetOfficesJanuary2012projectionsfortotalTreasurydebtoutstanding,

wegeneratethelevelandmaturitystructureofmarketabledebtoutstanding. Inaddition,we

assumethattheaveragematurityofTreasurydebtoutstandingextendsfromitscurrentlevel

of62monthsto70monthsby2015,consistentwiththeTreasurysstatedintentionsasof

November2011.26 Therefore,futureTreasurypurchasesareassociatedwithcouponsthat

evolveovertimereflectingprojectionsininterestrates,Treasuryissuance,andthe70percent

ownershiprule.

Asnotedabove,FederalReserveaccountingrecordsthesecuritiesholdingsatfacevalueand

recordsanyunamortizedpremiumordiscountintheotherassetscategory. Consequently,

wemustprojectboththefacevalueoftheportfolioandtheassociatedpremiums. Toproject

premiumsonfuturesecuritiespurchasesweneedtocalculatethemarketvalueofsecuritiesin

thefuture. Wetakethemarketvalueforsecuritiesasthepresentdiscountedcashflowof

thesesecuritiesusingthecouponratetogeneratecashflowsandtheyieldcurvesdescribedin

Section3.1andAppendix2todiscountthesecashflows. Thepremiumisthedifference

betweenthefacevalueandthemarketvalueofthesecurity. Treasurysecuritiesthatarerolled

overatauctionareassumedtobepurchasedatpar,andthereforehavenopremium.

ForMBSreinvestment,weneedtoprojectthecouponofthesecuritiesthatwillbepurchased.

ThemodelusedforthatisdescribedinAppendix2. Becausereinvestmentsareassumedto

continueonlyinthenearterm,weassumethatpurchasesofMBStakeplaceataprice4

percentabovefacevalue,consistentwithrecentMBSreinvestmentactivity.

3.2.2 LiabilitiesandcapitalInourmodeling,twoliabilityitemsareimportantexogenousdriversofthebalancesheet

contourFRnotesandtheTGA. Forsimplicity,weassumethatFRnotesgrowinlinewiththe

26RefertoMinutesoftheMeetingoftheTreasuryBorrowingAdvisoryCommitteetheSecuritiesIndustryand

FinancialMarketsAssociationNovember1,2011,availableathttp://www.treasury.gov/presscenter/press

releases/Pages/tg1349.aspx.

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BlueChipforecastfornominalGDP. Priorto2008,theleveloftheTGAwasfairlyconstantnear

$5billion.27 Sincethattime,however,theTreasuryhasmaintainedessentiallyitsentirecash

balanceintheTGAandtheTGAhasbeenvolatile,reflectingtheebbsandflowsofthe

Treasuryscashmanagementasborrowingandtaxreceiptsincreasethecashbalanceand

variousoutflowsreducethecashbalance.28 Fortheprojections,weassumethattheTGA

followstherecenthistoricalpatterninthenearterm,andthendropsto$5billionafterthelift

offofthefederalfundsrate. Capitalpaidinisassumedtogrowatitsdecadeaverageof15

percentperyear,andsurplusisequatedtocapitalpaidin. Thisgrowthrateplaysaroleinthe

longruntrendgrowthrateoftheSOMAportfolio.

Reservebalances,animportantliabilityitemfortheFederalReserve,areingeneralcalculated

astheresidualofassetslessotherliabilitieslesscapitalinthebalancesheetprojections.

However,weassumeaminimumlevelof$25billionissetforreservebalances. Thatlevelis

roughlyconsistentwiththelevelofreservebalancesobservedpriortothefinancialcrisis. Both

FRNotesandcapitalaretrendinghigherintheseprojections. Tomaintainreservebalancesat

$25billion,weassumethattheDeskbeginstopurchaseTreasurybills. Purchasesofbills

continueuntilthesesecuritiescompriseonethirdoftheFederalReservestotalTreasury

securityholdingsasnotedabove,abouttheaverageproportionofTreasuryholdingspriorto

thecrisis. Oncethisproportionofbillsisreached,weassumethattheDeskbuyscoupon

securitiesinadditiontobillstomaintainanapproximatecompositionoftheportfolioofone

thirdbillsandtwothirdscouponsecurities.

3.3 ExitstrategyassumptionsforthebalancesheetFortheneartermprojections,weassumethattheFOMCcompletesthecontinuationofthe

MEPpolicyannouncedinJune2012. Furtheroutintheprojectionperiod,webaseour

projections

on

the

general

principles

for

the

exit

strategy

that

the

FOMC

outlined

in

the

27ForadiscussionofTreasurycashmanagementduringthisperiod,refertoGarbade,PartlanandSantoro(2004).

28RefertoFRBNY(2011),pages2829.

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minutesoftheJune2011FOMCmeeting.29 TheCommitteestatedthatitintendedtotakethe

followingstepsinthefollowingorder:

(1)CeasereinvestingsomeorallpaymentsofprincipalonthesecuritiesholdingsintheSOMA;

(2)Modifyforwardguidanceonthepathofthefederalfundsrateandinitiatetemporaryreservedrainingoperationsaimedatsupportingtheimplementationofanincreasein

thefederalfundsratewhenappropriate;

(3)Raisethetargetfederalfundsrate;(4)Sellagencysecuritiesoveraperiodofthreetofiveyears;and(5)Oncesalesbegin,normalizethesizeofthebalancesheetovertwotothreeyears.

Tocompletetheprojections,however,weneedtomakeadditionalassumptions. Wetie

changesintheSOMAportfoliotothedatethefederalfundsrisesfromitseffectivelower

bound,basedontheBlueChipforecasts.Weassumethatthereinvestmentofsecuritiesends

sixmonthsbeforethisdate. Wedonotexplicitlymodeltheuseofreservedrainingtools.30 We

assumethatsalesofagencysecuritiesbeginsixmonthsafterthefederalfundsratebeginsto

riseandthatthebalancesheethasreturnedtonormalsizeoveraboutthreeyears. In

interpretingnormalsizewerelyonthe$25billionminimumlevelforreservebalancesas

normal. WesummarizetheassumedexitstrategyinTable3.31

29MinutesoftheFederalOpenMarketCommittee,June2122,2011,availableat

http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20110622.pdf.30Iftermdepositsorreverserepurchaseagreementswereusedtodrainreservespriortoraisingthefederalfunds

rate,thecompositionofliabilitieswouldchange:Reservebalanceswouldfallastermdepositsandreverse

repurchaseagreementsrose. Presumably,thesedrainingtoolswouldbewounddownasthebalancesheet

returnedtoitssteadystategrowthpath,sothattheprojectedpathforSOMAholdingspresentedhereremains

valid.31IftheexpecteddateofthefederalfundsliftoffislaterthanintheJune2012BlueChipforecast,thestartdates

fortheexitstrategyprincipleswillsimilarlybedelayedbutthecontoursoftheprojectionspresentedherewillbe

roughlyunchanged.

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Table3Keyassumptionsusedinbalancesheetprojections

AssumptionBaseline Laterliftoff Fastersales

MEPTreasuryPurchases

Amount $667 billion $667 billion $667 billion

Length 15 months 15 months 15 months

Firstmonth Oct11 Oct11 Oct11

Lastmonth Dec12 Dec12 Dec12

MEPTreasurySalesorRedemptions

Amount $667 billion $667 billion $667 billion

Length 15 months 15 months 15 months

Firstmonth Oct11 Oct11 Oct11

Lastmonth Dec12 Dec12 Dec12

CurrentPortfolioStrategy

Agencyreinvestments AgencyMBS AgencyMBS AgencyMBS

ExitStrategy

FedFundsliftoff Dec13 Oct14 Dec13

Redemptionsstart Jun13 Jun14 Jun13

Agencysales

Salesstart Jun14 Jun15 Jun14

Salesend May18 May19 May17

Otherlineitemsonthebalancesheetcontinueontheirprojectedpathasnotedabove.

4 ProjectionsInthissection,webeginwiththebaselineprojectionoftheFederalReservesbalancesheet.

ThebaselinescenarioprovidesausefulguidetohowtheFederalReservesbalancesheetmight

evolveunderreasonableassumptions. Next,weexaminetwootherscenariosthatvarysome

keyassumptionsoftheprojections. Inthefirst,theliftoffofthefederalfundsrateisdelayed

untillate2014,thedatereferencedintheJanuary2012FOMCstatement. Inthesecond,the

CommitteechoosesamoreaggressivepacefornormalizingthesizeoftheSOMAportfolioand

sellsMBSsecuritiesoverthreeyears. Westressagainthattheseprojectionsaretheresultof

theunderlyingassumptionsmadeaboutinterestratesandpolicydecisionsand,asaresult,are

notforecaststhemselves. Thepointoftheanalysishereistoestablishaframeworkforsuch

projections,anddifferentassumptionwould,ingeneral,resultindifferentprojections.

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4.1 BaselineFigures5and6presenttheprojectionsofkeybalancesheetlineitemsunderourbaseline

scenario. AsshowninthetopleftpanelofFigure5,SOMAholdings(thesolidline)remain

roughlyattheircurrentlevelof$2.6trillionthroughmid2013;theMEPandtheagency

securitiesreinvestmentpolicyimplythatthesizeoftheSOMAportfoliodoesnotchangeover

thattimeperiod. Afterthattime,undertheassumptionthattheFOMCbeginstoallowallasset

holdingstorollofftheportfolioasthefirststepintheexitstrategy,whosetimingisimpliedby

theinterestrateprojections,SOMAholdingsbegintodecline. NoticethatSOMATreasury

holdings,thetoprightpanel,remainconstantevenwhenrolloffbegins. Thisfactisaresultof

theMEPreducingholdingsofshorterdatedTreasurysecuritiestonearzero. MBSholdings,the

bottom

left

panel,

on

the

other

hand,

begin

to

contract.

Beginning

in

June

2014,

again

consistentwithourassumptionsabouttheexitstrategy,MBSsalesbegin,andtheseholdings

falltozerobyMay2018. Onbalance,theseactionsnormalizethesizeofthebalancesheetin

2017,fouryearsafterMBSsalesbegin.

ThereductioninthesizeoftheSOMAportfolio,alongwiththeprojectedgrowthofReserve

BankcapitalandFRnotes,resultsindeclinesinthelevelofreservebalances,showninthe

bottomrightpanelofFigure6. Asdescribedabove,weassumethatreservebalancesarenot

allowedtofallbelow$25billion. Therefore,in2017,theseprojectionsassumethattheDesk

againstartstoreinvestmaturingTreasurysecuritiesandbeginspurchasesofTreasury

securities. Afterthispointintime,theSOMAportfolioexpandsinlinewithFRnotesandcapital

andreservebalancesremainconstant.

Itisin2017,whenthebalancesheetisnormalized,thattheFederalReservesexcesssecurities

holdingsdroptozero. Thatis,privateholdingsofsecuritiesarebacktonormalandindicate

that

market

participants

believe

it

is

about

four

years

from

now

when

unconventional

monetarypolicyhasessentiallyunwound.

4.2 LaterliftoffAsshowninFigure4,underthelaterliftoffscenario(thelongdashedline),thefederalfunds

raterisesabovetheeffectivelowerboundinOctober2014oneofmanypossible

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interpretationsofthedatereferencedintheJanuarythroughAugust2012FOMCstatements

thatstatedeconomicconditionsarelikelytowarrantexceptionallylowlevelsforthefederal

fundsrateatleastthroughlate2014. Westress,however,thatthisassumption,likeallothers,

istosomedegreearbitraryandcouldbeadjusted. Weleavethepathoftheyieldofthe10

yearTreasurynoteunchangedforsimplicity.

Thechangeinthetimingofliftoffinthisscenarioaffectsthetimingoftheexitstrategy,andasa

result,thecontoursofthebalancesheetandincome. Theportfoliostaysroughlyconstantuntil

mid2014,and,asseeninFigures5and6,totalSOMAholdingsandreservebalancesremainin

linewiththebaselineinthenearterm. Astheassumeddateofliftoffapproachesand

securitiesareallowedtomatureoraresold,theSOMAportfolionormalizesinsizealittleless

thanonehalfyearlaterthaninthebaseline,inearly2018. SalesofMBScontinuethroughearly

2019,andthecompositionofthebalancesheetnormalizesaroundthattimeaswell.

Thisscenariohighlightsthatthislaterliftoffdelaystheexitofaccommodativepolicyby11

monthsrelativetothebaseline. Henceifmarketparticipantsshifttheirviewofexittowardthe

guidanceprovidedintheJanuary2012statementthateconomicconditionsarelikelyto

warrantexceptionallylowlevelsforthefederalfundsrateatleastthroughlate2014,sucha

shiftwouldimplythattheportfolioisexpectedtoremainlargeforalongerperiod,andasa

result keeplongerterminterestratesdepressedatouchlongerthanwhatisexpectedinthe

baselinecase.

4.3 FastersalesTheCommitteehasstatedthatitultimatelyintendstoreturntheSOMAportfoliotoholding

onlyTreasurysecurities. WeassumeinthebaselinethatthesaleofMBStakesplaceoverfour

years,butthepacecouldbefaster. Forthisscenario,weassumethatthefederalfundsrate

risesabovetheeffectivelowerboundatthesametimeasunderthebaseline,butthatsalesof

MBStakeplaceoverthreeyearsinsteadoffouryears. Allotherassumptionsareunchanged

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fromthebaseline.32 AsshowninFigure5,thefastersalesimplythatthesizeoftheSOMA

portfolioreturnstonormalfivemonthsearlierthanthebaselinescenario,inMarch2017. In

addition,asshowninFigure6,thelevelofreservebalancescontractssomewhatfasterthan

underthebaselineduringthesalesofMBS.

Comparedtothebaseline,accommodationwillberemovedfasterinthemediumterm. So,

longerterminterestrateswillmoveupabitfasterthaninthebaselineaswell.

5 ConclusionInthispaperwehaveoutlinedthemechanicsoftheFederalReservesbalancesheetandhow

assumptionsaboutmonetarypolicyaffecttheoutlookforthebalancesheetthroughtime.

Underthebaselineprojections,derivedfrompubliclyavailableforecastsabouttheeconomy

andpublicstatementsbytheFOMC,thebalancesheetremainsconstantforacoupleofyears

beforecontractinggradually,andonlyreturningtoitslongrungrowthpathinmid 2017. This

result,ifitisexpectedbymarketparticipantsandweretoberealizedinpractice,wouldimply

thatunconventionalmonetarypolicyactionswouldbeholdinginterestratesdown,tosome

degree,foranumberofyears.

Todemonstratethesensitivityofsuchprojectionstoalternativeassumptions,andto

underscorethefactthattheseprojectionsarenotforecastsperse,butrather,theresultofa

setofassumptions,weprovidedalternativescenarios. Theseprojectionsprovidesome

guidanceintohowalternativeassumptionsabouttheremovalofunconventionalmonetary

policywouldaffecttheFederalReservesbalancesheetand,hence,longerterminterestrates.

32Presumably,sellingMBSatafasterratewouldtendtoincreaseinterestratesrelativetothebaseline,asthe

privatesectorwouldneedtobecompensatedforholdingadditionalinterestraterisk. Wedonotmodelthiseffect

inourprojections,butitwouldlikelycauserealizedlossesonsalestobeslightlyhigherthanmodeledhere.

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6 BibliographyBoardofGovernorsoftheFederalReserveSystem. 1976. BankingandMonetaryStatistics,

19141941.

Chung,Hess,Laforte,JeanPhilippe,Reifschneider,David,andWilliams,JohnC. 2011. Have

WeUnderestimatedtheLikelihoodandSeverityofZeroLowerBoundEvents?FederalReserve

BankofSanFranciscoWorkingPaper201101,January.

Edwards,CherylE. 1997. OpenMarketOperationsinthe1990s,FederalReserveBulletin,p.

859874.

FederalReserveBankofNewYork. 2011. DomesticOpenMarketOperationsin2010,

availablefordownloadat

http://www.newyorkfed.org/markets/Domestic_OMO_2010_FINAL.pdf

Garbade,KennethD.,Partlan,JohnC.,andSantoro,PaulJ. 2004. RecentInnovationsin

TreasuryCashManagement,CurrentIssuesinEconomicsandFinance,FederalReserveBankof

NewYork,vol.10,no.11,November.

Gurkayank,Refet,Sack,Brian,andWright,Jonathan. 2007. TheU.S.Treasuryyieldcurve:

1961tothepresent,JournalofMonetaryEconomics,p.22912304,November.

Ihrig,Jane,Klee,Elizabeth,Li,Canlin,Schulte,Brett,andWei,Min.2012. Expectationsabout

theFederalReservesBalanceSheetandtheTermStructureofInterestRates,forthcoming

FederalReserveFinanceandEconomicsDiscussionSeriespaper.

Judson,Ruth,andPorter,Richard. 1996. TheLocationofU.S.Currency:HowMuchis

Abroad?,FederalReserveBulletin,vol.82,p.883903,October.

Meltzer,Allan. 2010. AHistoryoftheFederalReserve,Volume2,19511986,Universityof

ChicagoPress.

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Rudebusch,GlennD. 2011. TheFedsInterestRateRisk,EconomicLetters,FederalReserve

BankofSanFrancisco,April11.Yellen,Janet. PerspectivesonMonetaryPolicy,speechatthe

BostonEconomicClubDinner,Boston,Massachusetts,June6,2012.

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Appendix 1: Overview of assumptions underlying the Balance

Sheet projections

Thisappendixprovidesdetailsabouttheforecastingprocedureforeachbalancesheetitem.

ThosenotspecificallydiscussedareheldattheirlevelasofMay31,2012.

6.1 TreasurysecuritiesSOMATreasuryholdingsareassumedtoevolvethroughacombinationofoutrightpurchases

andoutrightsalesinthesecondarymarket,reinvestmentatauction,andmaturities.

Outrightpurchasesforthe$667billionMaturityExtensionProgram(MEP)aresimulatedaccording

to

the

maturity

buckets

and

targets

as

announced

by

the

Federal

Reserve

BankofNewYork:

MaturityExtensionProgrampurchasedistribution

(percent)

Nominalcouponsecurities TIPS

68years

810

years

1020

years

2030

years

32 32 4 29 3

SecuritiesassumedtobeavailableforpurchasereflectthoseoutstandingontheMonthlyStatementofthePublicDebtasofMay31,2012aswellasforecastsforfuture

issuance. HoldingsofanyparticularCUSIParelimitedto70percentoftheCUSIP

outstanding,consistentwiththeDeskscurrentpractice.

SalesandmaturitiesassociatedwiththeMEPwilltakeplaceinTreasurysecuritieswithremainingmaturitiesofuptothreeyears.

ThetotalparvalueofTreasurysecuritiesoutstandingreflectstheCongressionalBudgetOffices(CBO)projectionsfortotaldebtheldbythepublic.

TheaveragematurityofTreasurydebtextendsfromitscurrentvalueof60monthsto70months,consistentwithobservationsmadebytheTreasuryBorrowingAdvisoryCommitteeinNovember2011.

33

TheproceedsfrommaturingsecuritiesarereinvestedatauctionatratesconsistentwiththeBlueChipforecastforinterestrates,asdiscussedinAppendix2. Auctionsizesare

determinedbytheamountoftotaldebtnecessarytomatchCBOprojectionsandfollow

33Refertohttp://www.treasury.gov/presscenter/pressreleases/Pages/tg1349.aspx.

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25

adistributiondeterminedbyactualauctionsthroughMay2012.Thisdistributionisthen

alteredasnecessarytoextendtheaveragematurityofTreasurydebt. TheCBOsdebt

projectionsalongwiththematuritydistributionofsecuritiesauctionedinNovember

2011aresummarizedinthetablesbelow.

Year

CBOdebt

heldby

thepublic

($Billion)

Buckets

May2012

Issuanceby

bucket($

Billion)

Initial

sharesof

issuance

2010 9,019 1month 120 0.22

2011 10,128 3month 120 0.22

2012 11,242 6month 108 0.2

2013 11,945 1year 25 0.05

2014 12,401 2year 35 0.072015 12,783 3year 32 0.06

2016 13,188 5year 35 0.07

2017 13,509 7year 29 0.05

2018 13,801 10year 21 0.04

2019 14,148 30year 13 0.02

2020 14,512 Source: Wrightson,AuctionCalendar

2021 14,872

Source:CBO,Jan.2012TheBudgetandEconomicOutlook:FiscalYears2012to2022

Theagencysecuritiesportfolioisassumedtoevolveduetoacombinationofpurchases,sales,

andprepayments.

ConsistentwiththeFOMCsstatementaftertheSeptember2011FOMCmeeting,principalpaymentsfromSOMAagencyMBSanddebtandarereinvestedinagencyMBS.

WeuseacurrentcouponmodeltoestimatethecoupononnewlypurchasedMBS

securitiesbasedontheconsensuslongrunBlueChipforecastforthe10yearTreasury

rate,reviewedinAppendix2.

PrepaymentsonsettledagencyMBSholdingsasofMay31,2012aregeneratedbyapplyingtherealizedprepaymentrateontheSOMAholdingsofMBSfromJune2010to

July2011(theperiodwhentherewerenonewholdingsofMBSsettlingintheSOMA

portfolio)onmonthlyholdingsfromJune2012tothefederalfundsliftoff,inDecember

2013. Thisprepaymentrateisnotablyfasterthanwhatwouldbepredictedusingthe

standardPSAprepaymentmodel,likelyaresultofthehistoricallylowlevelofmortgage

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26

rates. Afterthefederalfundsrateliftsoff,wegraduallysmooththeprepaymentrate

backtothelongrunPSAmodeloverafiveyearperiod.

PrepaymentsonanticipatedfuturepurchasesofagencyMBSfollowthelongrunPSAmodelforthelifeofthesecurity.

Sales

of

agency

securities

begin

six

months

after

the

first

increase

in

the

federal

funds

rateandlastforfouryears. ThistimingisconsistentwiththatlaidoutintheJune2011

FOMCMinutes;however,theexacttimingismerelyillustrativeandchosensoastobe

easilyimplementableinourprojections.

Undertheseassumptions,andgiventhematurityscheduleforagencydebtsecurities,thevolumeofsalesnecessarytoreduceholdingsofthesesecuritiestozerooverthe

fouryearperiodonlyrequiresasixmonthperiodofminimalsalesneartheendofthose

fouryears.

6.1.1 PremiumsanddiscountsApremium(discount)istheamountpaidabove(below)theparvalueofasecurity. Asof

March31,2012,theFederalReservehad$99billioninnetunamortizedpremiumsonTreasury

securities,$4billiononagencydebtsecurities,and$12billiononagencyMBS. Weusestraight

lineamortizationofthesepremiumsanddiscountsovertheexpectedlifeofcurrentSOMA

holdings. WederivenewpremiumsanddiscountsfromoutrightTreasurypurchasesbyusing

thedifferencebetweentheassumedcouponofthesecuritybeingpurchasedandthe

correspondingmarketinterestrate,asgivenbytheyieldcurveestimatesreviewedinAppendix

2. WeassumethatagencyMBSarepurchasedataprice4percentaboveparvalue,and

thereforebooksomepremiumsontheseassetpurchases. Basedonthecalculationsforthe

purchasepricesofTreasurysecurities,weestimatethatthereareapproximately$60billionin

premiumsassociatedwithTreasurysecuritiespurchasesoverthecourseoftheMaturity

ExtensionProgram.

6.1.2Discount

window

lending

Wemakethesimplifyingassumptionthatalldiscountwindowlendingovertheprojection

periodiszero.

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27

6.1.3 TALFLLCAssetsheldbyTALFLLCconsistofinvestmentsofcommitmentfeescollectedbytheLLCandthe

U.S.Treasurysinitialfunding. Inthisprojection,theLLCdoesnotpurchaseanyassetbacked

securitiesreceivedbytheFederalReserveBankofNewYorkinconnectionwithadecisionofa

borrowernottorepayaTALFloan. TheassetsheldbyTALFLLCremainattheircurrentlevelof

about$1.0billionthrough2014beforedecliningtozerothefollowingyear.

6.1.4 MaidenLane,MaidenLaneII,andMaidenLaneIIITheassetsheldbyMaidenLaneLLC,MaidenLaneIILLCandMaidenLaneIIILLCdecline

graduallyovertimereflectingknownsalesintheneartermandaslowdroptozerothereafter.

HoldingsforallthreeLLCsfalltozerobyearly2015.

6.1.5 ReservebalancesReservebalancesaretheresidualofassetslessotherliabilitieslesscapitalinthebalancesheet

projection. Thatsaid,aminimumlevelof$25billionissetforreservebalances,roughly

equivalenttothelevelofreservebalancesbeforethestartofthefinancialcrisis. Tomaintain

reservebalancesatthislevel,firstTreasurybillsarepurchased. Purchasesofbillscontinueuntil

thesesecuritiescompriseonethirdoftheFederalReservestotalTreasurysecurityholdings

abouttheaveragelevelpriortothecrisis. Oncethislevelisreached,theFederalReservebuys

notesandbondsinadditiontobillstomaintainanapproximatecompositionoftheportfolioof

onethirdbillsandtwothirdscouponsecurities. Ingeneral,increasesinthelevelofFederal

Reserveassetsaddreservebalances. Bycontrast,increasesinthelevelsofliabilityitems,such

asFederalReservenotesincirculationorotherliabilities,orincreasesinthelevelofReserve

Bankcapital,drainreservebalances.

6.1.6 CurrencyFederalReservenotesincirculationareassumedtogrowatthesamerateasnominalGDP. We

usetheconsensusBlueChipforecastsforrealGDPgrowthandthepriceleveltoformthe

forecastfornominalGDPthroughSeptember2013. Becausethisisanannualforecast,weuse

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28

theannualgrowthrateastheannualizedquarterlygrowthrateforthe2ndand3

rdquartersof

eachyear,andtheninterpolategrowthratesforthe1stand4

thquartersoftheyear. Thetable

belowsummarizestheBlueChipprojectionsfornominalGDPgrowth.

YearBlue

Chip

nominalGDP

growth

forecast

2012 4.4%

2013 4.8%

2014 5.0%

2015 5.2%

2016 5.1%

2017 5.0%

2018 4.9%2019 4.6%

2020 4.6%

Source:BlueChip,June2012

6.1.7 ReverseRepurchaseAgreements(RRPs)TheFederalReserveconductsRRPswithforeignofficialaccounts,internationalaccounts,and

othercounterparties. ThevolumeofRRPsthatisconductedwithforeignofficialand

internationalaccountsisassumedtostayconstantatitsmostrecentlevelofapproximately$98

billioninMay2012. Theportionthatisconductedwithothersisassumedtostayatzeroover

theprojectionperiod.

6.1.8 U.S.TreasurysGeneralAccount(TGA)TheTGAcashbalanceisprojectedtofollowtherecenthistoricalpatterninthenearterm,and

thendropsto$5billionaftertheliftoffofthefederalfundsrate.

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29

6.1.9 SupplementaryFinancingAccount(SFA)WemaintaintheSFAbalanceatitscurrentlevelofzerothroughouttheforecast,consistent

withtheTreasuryBorrowingAdvisoryCommitteesrecommendationnottoresumethe

programatthistime.34

6.1.10CapitalFederalReservecapitalgrows15percentperyear,inlinewiththeaveragerateofthepastten

years.

6.1.11DeferredAssetIntheeventthataFederalReserveBanksearningsfallshortoftheamountnecessarytocover

operatingcosts,paydividends,andequatesurplustocapitalpaidin,adeferredassetwillbe

recorded. ThisdeferredassetisrecordedinlieuofreducingtheReserveBankscapitalandis

foundontheliabilitysideofthebalancesheetasInterestonFederalReservenotesduetoU.S.

Treasury. Thisliabilitytakesonapositivevaluewhenweeklycumulativeearningshavenotyet

beendistributedtotheTreasury,whilethisliabilitytakesonanegativevaluewhenearningsfall

shortoftheexpenseslistedabove.

34RefertoMinutesoftheMeetingoftheTreasuryBorrowingAdvisoryCommittee,theSecuritiesIndustryand

FinancialMarketsAssociation,November1,2011,availablefordownloadathttp://www.treasury.gov/press

center/pressreleases/Pages/tg1349.aspx.

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30

Appendix 2: Constructing yield curves and coupons on purchased

securities and valuation of the SOMA portfolio35

TheprojectionsforthecouponratesonTreasurysecuritiesdependonforecastsfortheyield

curve. Weconstructazerocouponyieldcurveusingprojectionsforthefederalfundsrateand

theforecastforthe10yearTreasuryyield,wheretheseindependentvariablesaretakenfrom

theJune2012BlueChipforecastforfutureinterestrates.

Wespecifytherelationshipbetweenayieldattenoriandtheseratesusingaregression:

1 2 (10 )it i i t i t it y ff year ,

whereyitisthezerocouponyieldformaturityiattimet,isaconstantterm,1iistheyield

specificcoefficientonthefederalfundsrate,2iistheyieldspecificcoefficientonthe10year

rate,anditisanerrorterm. Weevaluatethisspecificationonhistoricaldataatthe2,3,4,5,

10,15,20,and30yeartenors. Thehistoricaldataareyieldsconstructedfromanofftherun

SvenssonNelsonSiegelzerocouponyieldcurve,theTreasuryyieldcurveusedinproduction

workattheBoard.36 ThesampleisdailydatafromJanuary3,1994toApril10,2010. Standard

errorsarecalculatedusingarobustsandwichprocedure.

TheestimatedcoefficientsandassociatedRsquaredstatisticsaredisplayedintheappendix

tableA21. Ingeneral,theresultsareinlinewithintuitionandthesetworatescanexplain

almostallthevariationintheotherrates. Inaddition,weperformedaseriesofrobustness

checks. Specifically,longertermratestendedtoexhibitcointegrationwiththe10yearrate,

butshortertermratesdidnot. Overall,theestimatedcoefficientsandresultingyieldcurves

presentedherearebroadlysimilartothoseusingacointegratedorothertypeofspecification.

Withtheseestimatesinhand,wethenconstructinitialyieldcurvesforeachpointintimein

ourforecast,interpolatingvaluesfortenorsforwhichwedonotexplicitlyestimateamodel.

WeusetheseforourprojectedcouponsonTreasurysecuritieswepurchaseovertheforecast

period.

35MuchofthemethodologydescribedinthissectionisattributabletoViktorsStebunovsandAriMorse.

36Fordetails,refertoGurkaynak,SackandWright(2007).

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31

AnadditionalestimateisneededtoforecastthecouponrateonfutureMBSpurchases. Thisis

donebyestimatingthestatisticalrelationshipbetweentheFannieMaeMBScurrentcoupon

rateandthe10yearTreasuryrate. Weusequarterlyaveragesofdailydatafrom1984Q4to

2011Q3togenerateourparameterestimates. WeuseanARIMA(1,1,0)modeltoaccountfor

theautocorrelationintheerrortermsandthecointegrationinthetwoseries. Asisevident

fromtableA22,changesinthe10yearratearematchedalmostonetoonewiththoseinthe

MBScurrentcouponrate,andtheautocorrelationinthedifferencedseries,whilenotstrong,is

stillpersistentenoughtoberelevantintestsforautocorrelationoftheresiduals.

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TableA21:Yieldcurveregressions

Effectiverate 10yearrate Con

Year CoefficientStandard

errorTstat Coefficient

Standard

errorTstat Coefficient

St

2 0.536*** 0.003 155.438 0.746*** 0.007 109.305 0.018***

3 0.392*** 0.003 131.062 0.877*** 0.006 154.592 0.018***

4 0.282*** 0.002 116.573 0.945*** 0.004 211.367 0.015***

5 0.196*** 0.002 107.059 0.980*** 0.003 293.544 0.012***

7 0.071*** 0.001 87.829 1.003*** 0.001 678.057 0.006***

10 0.039*** 0 119.39 1.000*** 0.001 1420.984 0.002***

15 0.121*** 0.001 88.754 0.995*** 0.003 397.277 0.008***

20 0.149*** 0.002 64.611 1.013*** 0.004 269.745 0.010***

30 0.168*** 0.004 46.25 1.083*** 0.006 196.249 0.005***

N 4067

Sample: 1/3/19944/10/2010

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33

TableA22:MBScouponforecastingregression

ForecastingMBScurrentcoupon

Dependentvariable: (FannieMae30year

currentcoupon)

CoefficientStandard

errorZ

(10yearrate) 0.981 0.031 32.12

AR(1) 0.095 0.069 1.37

Constant 0.004 0.017 0.26

N 107

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Assets

Liabilities

Support for specific institutions (ML LLCs, Bear, AIG)

Other credit facilities (PDCF, AMLF, CPFF, TALF)

Central bank liquidity swaps

Loans (includes term auction credit)

All other assets

Agency debt and MBS holdings

Repurchase agreements

Treasury securities held outright

Federal Reserve notes in circulation

Reverse RPsCapital Other Liabilities>

U.S. Treasury accounts

Deposits of depository institutions

Other

0

500

1,000

1,500

2,000

2,500

3,000

3,000

2,500

2,000

1,500

1,000

500

$

Billions

Jan 4, 2006 Jul 5, 2006 Jan 3, 2007 Jul 4, 2007 Jan 2, 2008 Jul 2, 2008 Dec 31, 2008 Jul 1, 2009 Dec 30, 2009 Jun 30, 2010 Dec 29, 2010

Wednesdays

Figure 1 Federal Reserves Assets and Liabilities

Last updated July 7, 2012.

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1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

5

1

1

2

2

3$Billion

SOMACapital+NotesReserve Balances

Figure 2 - SOMA, Capital + FR Notes,and Reserve Balances

Source: H.4.1 Statistical Release

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Months

Figure 3 - Weighted Average Maturity of SOMA

Note. Includes only nominal Treasury securitiesSource: Federal Reserve Bank of New York and Center for Research in Security Prices

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Figure 4 - Interest Rates*

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

0

1

2

3

4

5

6

7percent

Baseline & Faster SalesLater Lift-off

Federal Funds Rate

Quarterly

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

2

3

4

5

6

7percent

Baseline & Faster SalesLater Lift-off

10 year Treasury Rate

Quarterly

* Baseline interest rate paths are the consensus June 2012 Blue Chip forecast; later lift off path are authors calculations

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Figure 5 - Selected Assets Projections

2006 2008 2010 2012 2014 2016 2018 2020

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000Billions of dollars

BaselineLater Lift-offFaster Sales

SOMA Holdings

Monthly

2006 2008 2010 2012 2014 2016 2018 2020

0

500

1000

1500

2000

2500

3000

3500



SOMA Treasury Holdings

Monthly

2006 2008 2010 2012 2014 2016 2018 2020

0

200

400

600

800

1000

1200

1400



SOMA Agency MBS Holdings

Monthly

Source: Authors Projections

2006 2008 2010 2012 2014 2016 2018 2020

0

100

200

300

400

500



SOMA Agency Debt Holdings

Monthly

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Figure 6 - Selected Liabilities Projections

2006 2008 2010 2012 2014 2016 2018 2020

0

200

400

600

800

1000

1200

1400

1600

1800



FR Notes

Monthly

2006 2008 2010 2012 2014 2016 2018 2020

0

20

40

60

80

100

120

140

160

180

200

220



Treasury General Account

Monthly

0

20

40

60

80

100

120

140

160

180

200



Capital Paid In

Monthly

0

500

1000

1500



Reserve Balances

Monthly

Documents

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